VI. WESTERN HEMISPHERE TRADE CORPORATIONS The following sections describe tax preferences available to specific foreign investors based on the geographical area of their investments. The 14 percentage point reduction in the U.S. tax rate applicable to Western Hemisphere trade corporations is, like the special computation of the credit on dividends from less developed countries, the result of excluding certain income from scope of a tax increase. It is available to U.S. corporations which derive virtually all of their income from trade or business in the Western Hemisphere. The special rate is arrived at by deducting from taxable income a fraction of that taxable income equal to 14 over the ordinary rate. Thus, since the denominator of the fraction reflects changes in the ordinary rates, such as the surcharge, the result is always a 14 percentage point reduction. The preference for Western Hemisphere trade corporations entered the law in 1942 as an exemption from surtax, then regarded as a temporary increase in taxes due to the war. It was argued that the increase in taxes put U.S. corporations at a competitive disadvantage in foreign markets compared to foreign corporations. The fact that the response was exemption from the tax increase and limited to that one area (because of the war there was little foreign business activity outside the Western Hemisphere) suggests that the measure was looked upon as temporary. The provision is used today primarily by corporations engaged in wholesale trade, but the great bulk of the deduction is taken by a few petroleum and other mineral companies. To qualify generally requires setting up a U.S. subsidiary to handle Western Hemisphere activities, but this requirement is probably a less discouraging factor than the advantages of deferral and the fact that the foreign tax rates frequently exceed the 34 percent U.S. rate and to that extent absorb the benefit of the rate reduction. VII. INCOME FROM U.S. POSSESSIONS AND CHINA TRADE ACT CORPORATIONS These two dissimilar sounding provisions were enacted into law as exceptions to the general principle of taxation of the worldwide income of U.S. residents, citizens and corporations in 1921 and 1922, respectively. In 1921 the House Ways and Means Committee proposed a broad exemption from U.S. tax of the foreign source income of taxpayers deriving more than 80 percent of their income from foreign sources. The recomUnder sections 921 and 922 of the Internal Revenue Code qualifying U.S. corporations must: (1) do all their business during the taxable year in the Western Hemisphere other than the United States (but including Canada), (2) derive at least 95 percent of their gross income of the three immediately preceding years from sources outside the United States, and (3) derive at least 90 percent of their gross income for the same period from the active conduct of a trade or business. mendation was strongly opposed in Congress on the grounds that it would mean taxing U.S. citizens and corporations unequally according to the source of their income, that it would favor large wealthy corporations, and that there was no reason to favor foreign over domestic investment. The major interest in such an exemption seems to have been voiced by taxpayers operating in the Philippines (then a possession) and China. It is not clear what policy considerations entered into the compromise which limits the exemptions to foreign source income of taxpayers based in the possessions and engaged in trade with China. The possessions are now defined to include the Panama Canal Zone, Guam, American Samoa, Wake Island and the Midway Islands and Puerto Rico (but not for individual citizens who are able to exclude income from Puerto Rican sources under another section). Under Code section 931, enacted in 1921, U.S. citizens and corporations which for a three-year period derive at least 80 percent of their gross income from U.S. possessions and at least 50 percent of their gross income from the active conduct of a trade or business in a possession are exempt from U.S. tax. The effect for a U.S. corporation is to treat it as if it were incorporated abroad. Foreign incorporation was uncommon in 1921. Sections 941 through 943 of the Code were enacted in 1922 to improve the competitive position of U.S. firms relative to British firms in exporting to China, which was a large and growing market and of particular importance in the context of the post-World War I depression. The provisions are more restrictive than those applicable to income from the possessions in that only income from sources within China, not all foreign source income, is exempt from U.S. tax. To enjoy the exemption, the income must be distributed currently to shareholders who are residents of the United States or China or U.S. citizens. Dividends paid by such corporations to residents of China are exempt from U.S. tax, but this does not benefit a U.S. corporation. Moreover, "China” now includes only Formosa and Hong Kong. Only one or two corporations now claim the benefits of these provisions. I. HISTORICAL PERSPECTIVE. II. THE GROWTH OF FOREIGN U.S. "Instead of being viewed as a rival, (foreign investment) ought to be considered as a most valuable auxiliary, conducing to put in motion a greater quantity of productive labor, and a greater portion of useful enterprise, than could exist without it." Alexander Hamilton It is widely recognized that the mainspring of U.S. economic development during the first century and one-quarter of our existence as a nation was foreign direct investment. Following World War I, however, foreign investment here receded into a secondary role; with the shift of the United States from a debtor to a creditor nation, U.S. capital investment flows abroad have by far overwhelmed foreign capital investment in the United States. Nevertheless, such foreign direct investment remains not insignificant in amount and impact. Capital investment inflows now run to about $1 billion a year, and the value of foreignowned productive assets amounts to some $11 billion. Foreign investment has an impact on U.S. economic life at a number of points. It affects both the current and capital accounts of the U.S. balance of payments; it has been the vehicle for the introduction and development of considerable new technology, with consequent domestic productivity gains; and it has served to generate domestic income and employment, not infrequently in depressed areas. These and the related reasons developed in the following pages sug gest that a review of foreign direct investment in the United States would be of value at this juncture. S. Stanley Katz is Deputy Director, Office of Foreign Direct Investments, Department of Commerce. The views expressed in this paper do not necessarily reflect those of the Department of Commerce. Assistance from Jean McGurrin and Thomas Pierpoint is gratefully acknowledged. I. HISTORICAL PERSPECTIVE1 British, French, Dutch and German investments in the United States in the early days of this nation were largely responsible for erecting the infrastructural base on which were built our national economic fortunes. Foreign investment in the early 1800's, estimated to have totaled some $60 million, comprised about one-quarter of all business equity holdings, one-half of the Federal public debt, and two-thirds of the shares in Hamilton's National Bank. The importance of such capital is evidenced by the developments that it helped finance. The Louisiana Purchase was funded with some $11 million raised in foreign markets. Initial efforts of the early 1800's to link the nation by canals, roads, and bridges were largely financed by foreign investors. As a consequence, foreign capital investment, largely in transportation infrastructure, amounted to some $200 million by 1837. The expansion of railroads which started in the 1850's was similarly made possible by foreign capital. In 1869, Europeans held over $240 million in U.S. railroad securities; by 1914, this figure had risen to $4 billion. In the latter half of the 19th century, foreign investment moved into more direct production activities. Land companies, financing institutions, mining and petroleum, milling and textiles were the main objects of foreign investment during that period. By 1914, total foreign investment in the United States had reached some $7 billion. Although the United States shifted from a net importer to a net exporter of capital during World War I, foreign capital investment has continued to flow to this country in substantial amounts. During more recent decades, many products and much technology now "made in U.S.A." were, in fact, introduced to the American economy by foreign investors. Who, for example, would question the nationality of such products as Lux soap, Pepsodent toothpaste, Super Shell gasoline, and Good Humor ice cream, each of which is pronounced by a foreignowned corporation? II. THE GROWTH OF FOREIGN U.S. INVESTMENT In reviewing the movement of foreign investment to the United States during the past several decades, it is important to bear in mind the scope of the investment under consideration and the way in which it has been valued. Foreign U.S. Investment--Definitions For purposes of this paper, the value of foreign direct investment is expressed in terms of the initial book value of the assets acquired or 1 Much of the material in this section is taken from Hacker, Louis M., “Foreign Investments in America's Growth," U.S. Information Service, 1967. Historical data include both direct and portfolio investment. installed. No endeavor has been made to convert book value to a current replacement or other adjusted basis. The definition of foreign direct investment used here corresponds to the definition provided in Chapter VIII of the "Federal Register" with respect to the required reporting of investment to the Department of Commerce, Office of Business Economics (under the Bretton Woods Agreements Acts). In brief, foreign direct investment as here used includes investments by corporations, partnerships, individuals, banks, insurance companies and any other business enterprise subject to the jurisdiction of the United States in which foreign persons (as individuals or affiliates) hold, directly or indirectly, a controlling interest. Controlling interest is deemed to exist for corporations where 25 percent or more of the voting shares is beneficially foreign held; for all branches (including banks), leaseholds, real property or other unincorporated business which are owned in part or full by foreign persons or entities; and for insurance company branches where 25 percent or more of the voting stock is held by foreign owners. Investment in a business enterprise (other than a U.S. branch or agency of a foreign bank) which, in terms of foreign-owned equity, is less than $2 million ($3 million for banks) is excluded from investment as here defined. Direct investment in non-profit enterprises by religious bodies, charitable organizations and other non-profit organizations is also excluded. For purposes of analysis, total foreign direct investment is divided by source into (1) net new investment, which is the first reported capital inflow to establish or acquire a new company or operation in the United States, and the cost of acquiring additional shares of an existing company (less disinvestment); (2) reinvested earnings; and (3) adjustments for changes in financial asset values, principally of securities held by foreign-owned insurance companies. The relative shares of these components in total direct investment are shown in Table 4 below. Investment Trends The value and national ownership of foreign direct investment in the United States is shown in Table 1 for selected past years. These data indicate an accelerating pattern of foreign direct investment between 1950 and 1969. The annual increase in book value of foreign-owned U.S. assets was in the $200-300 million range during much of the fifteen-year period from 1950 to 1965. For 1968 and 1969, the respective annual inflows were $900 million and $1 billion. As a consequence, the value of such investment, which was $3.4 billion in 1950, has increased to $11.8 billion in 1969 or by a factor of 2.5 in 20 years. Foreign direct investment, nonetheless, plays a fairly modest role in U.S. domestic capital formation. It virtually vanishes in relation to such broad aggregates as annual gross private domestic investment (which amounted to $140 billion in 1969) and is of little more significance in |